January 25, 2009

In the text, the authors have discussed the importance of institutions in installing incentives to entrepreneurship, and thus economic growth. All of the institutions necessary for economic growth can be summarized broadly by using the terms “good government” and “well-functioning markets”. But can entrepreneurship and economic growth occur without the existence of government? Such is the situation in Somalia where no unified government exists, and anarchy thrives. Yes, the telecommunications industry is thriving. Read the article below, which is an excerpt from a BBC article (www.bbc.co.uk). Then discuss the following two questions:

1. Does the absence of government encourage business activity?

2. Given your knowledge of the institutions that are necessary for economic activity, discuss which of these institutions are missing in Somalia.

Rising from the ruins of the Mogadishu skyline are signs of one of Somalia's few success stories in the anarchy of recent years. A host of mobile phone masts testifies to the telecommunications revolution which has taken place despite the absence of any functioning national government since 1991.

Three phone companies are engaged in fierce competition for both mobile and landline customers, while new internet cafes are being set up across the city and the entire country. It takes just three days for a landline to be installed - compared with waiting-lists of many years in neighboring Kenya, where there is a stable, democratic government. And once installed, local calls are free for a monthly fee of just $10. International calls cost 50 US cents a minute, while surfing the web is charged at 50 US cents an hour - "the cheapest rate in Africa" according to the manager of one internet cafe.

But how do you establish a phone company in a country where there is no government?

No monopoly

In some respects, it is actually easier.

There is no need to get a license and there is no state-run monopoly which prevents new competitors being established.

And of course there is no-one to demand any taxes, which is one reason why prices are so low.

"The government post and telecoms company used to have a monopoly but after the regime was toppled, we were free to set up our own business," says Abdullahi Mohammed Hussein, products and services manager of Telcom Somalia, which was set up in 1994 when Mogadishu was still a war-zone.

"We saw a huge gap in the market, as all previous services had been destroyed. There was a massive demand."

The main airport and port were destroyed in the fighting but businessmen have built small airstrips and use natural harbors, so the phone companies are still able to import their equipment.

Despite the absence of law and order and a functional court system, bills are paid and contracts are enforced by relying on Somalia's traditional clan system, Mr. Abdullahi says.

Mobile target

But in a country divided into hundreds of fiefdoms run by rival warlords, security is a major concern. While Telcom Somalia has some 25,000 mobile customers - and a similar number have land lines - you very rarely see anyone walking along the streets of Mogadishu chatting on their phone, in case this attracts the attention of a hungry gunman... The phone companies themselves say they are not targeted by the militiamen, even if thieves occasionally steal some of their wires... Mr. Abdullahi says the warlords realise that if they cause trouble for the phone companies, the phones will stop working again, which nobody wants... (Article continues on BBC webpage, but is truncated here for purposes of this question.)

Questions:

1.) Does the absence of government encourage business activity? Are there benefits for consumers as well?

2.) Given your knowledge of the institutions that are necessary for economic activity, discuss which of these institutions are missing in Somalia.

Answers:

1.) It is an unusual situation to find an economy without a government, and so when we do find one, it is certainly very useful as a contrast study to other economies. Governments exist in almost all other economies in the world, and so the textbook has identified institutions that can be associated with “good government” and has discussed how these institutions can encourage growth. In Somalia, business is thriving in the absence of a legal system, and a regulatory government. There are some benefits to this, but also some costs. One of the benefits is that businesses do not have to overcome any bureaucracy, so they are not facing a delay in start up costs and time related to red tape. Since there is no government, there is also no threat of corruption and loss of resources related to bribes.

The absence of government also ensures that there are no taxes to pay. These benefits do represent savings for firms that want to operate in this kind of an environment, and thus if one looks at cost savings along, the incentive for business is much greater than in a country that does have a government. The biggest benefit to consumers is the lower cost of the product.

In spite of all these benefits as discussed, there are also significant costs to running a business that has no government. As the last part of the article discusses, people hardly walk around talking on their cell phones because they do not want to attract the attention of some mercenaries. When no government is present, there is no official system to enforce property rights. There is no legal recourse when one’s property is taken away forcibly by another person. The same is true for firms – they have no recourse to the legal establishment of property rights. Although the warlords are not attacking the assets of the telecoms industry in Somalia because they have a self-interest in seeing it preserved, this does not mean that they would not attack other types of industries, particularly if they are owned by rival clans. It is interesting that this is a clear application of Adam Smith’s invisible hand where the warlords are acting out of self interest in seeing the telecom service provided.

If the Somali gunmen and mercenaries were to attack other firms in other industries, then there is no police protection (unless there is a system of private police). It is interesting to note that the clan system establishes the payment of bills and the establishment of contracts so that consumers pay the firms, and the firms provide the services they promise. Thus there is indeed a form of authority that is governing this market. You can think of the clan system as a form of government.

Note that the absence of government means that there is no central agency establishing standards for product attributes and quality. For example, the Food and Drug Administration in the United States checks to see whether products are safe for human consumption. Since there is no central authority like this in Somalia, there are no central guidelines for producers to follow, and this means that consumers could be getting dangerous products.

2.) Property rights and a well functioning legal system are key among the missing institutions in Somalia. Without a government in place, there are no legal title deeds, and though a pseudo-government does exist in the form of a clan system, there is no official property rights identification system, and no official courts to settle disputes.

Incentives for entrepreneurship do exist to a certain extent because firms stand to make large profits in the absence of corruption and taxes. In the telecoms industry in Somalia, the markets are indeed competitive as firms compete to provide services to their consumers in the hope of more profit.

However, it is possible that cost savings due to zero taxes and lack of bribes’ charges could at some point be replaced by “protection” costs exacted by different warlords. Currently there is an absence of “honest government” because no government exists! But if the warlords do start exacting protection money then they would become like dishonest government.

Certainly political stability is very much lacking, as there is no unified government, and no official police force to watch over consumers and firms and protect their assets.

It is a testament to the entrepreneurial spirit that it can survive and thrive under conditions like this, and Somalia is a clear example of Adam Smith’s invisible hand at work. The telecoms firms are existing and working out of self interest (profit), and the warlords are not attacking their firms because of their self-interest (communications), and thus a country in anarchy is able to enjoy the benefits of a modern communication system. The example of Somalia also highlights how certain types of businesses can survive if they are providing a key service even in the absence of almost all the institutions for economic growth. However, this is a rarity and in general all the institutions of “good government” are needed for real GDP per capita to rise.

December 16, 2008

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings.

Amazing, onion farmers and Congress panic in 1958 with the Senate Committee arguing that

...speculative activity in the futures markets causes such severe and unwarranted fluctuations in the price of cash onions…[that a] complete prohibition of onion futures trading [is necessary] in order to assure the orderly flow of onions in interstate commerce...

and for going on fifty years onion futures are banned. Makes me want to cry.

More here on the banning of futures markets. (A report from 1956 indicates that the fluctuations at that time were due to an attempted swindle.)

Earlier this year, 2008, there was much worry in the news and among consumers paying then record high gasoline prices about the effects of oil speculators in the crude oil market. Well it turns out there is at least one market in the U.S. where the law bans all futures trading: onions.

Read the underlying short article in Fortune hyperlinked above. You should also realize that at least some people who buy futures contracts are speculating in the commodity in question.

Questions:

1.) What did you learn from Chapter Five in the Cowen/Tabarrok textbook about what speculation and futures trading will do to market price? Do speculation and futures markets affect how much and how frequently prices change?

2.) What do the Marginal Revolution post and the Fortune article tell us has happened to onion prices in the 50 years since futures in onions were banned? What do you expect the ban on onion futures trading has done to the risk and production of onion growers?

3.) What would you expect to happen to crude oil and gasoline prices if Congress banned futures trading in crude oil? How would this effect the economy overall?

Answers:

1.) In Chapter Five of the Cowen/Tabarrok textbook we learn that speculation moderates changes in prices. Speculation will lead to the price of a good not changing as much, and will make the good more available during times it is scarcest. Speculators raise the price of a good today if they expect its price to rise, but that leads to the price being lower that it would have otherwise been in the future.

2.) The article points out, “the volatility in onion prices makes the swings in oil and corn look tame,” as we would expect from reading Chapter Five in the Cowen/Tabarrok textbook. Specifically, the article discusses that since 2006, while oil prices at that time of the article, June 2008, were up 100%, and corn had risen 300%, onion prices rose 400% between October 2006 and April 2007 due to weather related crops reductions, then crashed 96% by March 2008 on overproduction and then bounce back up 300% by April 2008.

At least one person in the onion market recognizes that it would likely operate with less volatility, if a futures trading were legal. Bob Debruyn of Debruyn Produce, a Michigan-based grower and wholesaler says, "I would think that a futures market for onions would make some sense today, even though my father was very much involved in getting rid of it."

Since onion growers can not lock in a price for their production, onion growing is riskier than other crops. Thus we might see less onion production due to this extra risk.

3.) The inference that students should draw is that crude oil and gasoline prices would likely be more volatile as onion prices are, if Congress were to act to try to stop speculation in the crude oil market.

Most of us do not have a large demand for onions. Onions are not a huge part of our budgets, even if we run a restaurant. Products from crude oil, particularly gasoline are a different story. Gasoline is an important item in many consumers’ budgets. It is an important part of transportation costs of many other goods. Crude oil is important in heating many consumers’ houses. Thus wide fluctuations in crude oil prices would be much more disruptive to the economy than similar fluctuations in onion prices have been. So a Congressional ban on futures trading in crude oil would cause more volatility in crude oil and gasoline prices and would be disruptive to the economy.

December 11, 2008

The Marginal Revolution blog by the authors of the book is not the only one to use a topic like “markets in everything.” The Café Hayek blog has this post on the market for Canadian passports after the U.S. started requiring Canadian citizens have a passport to visit. They put this post under their “Markets in Everything” topic.

Activity:

Read the post at the link above.

Questions:

1.) What happened to the market for Canadian passports when the U.S. changed its visit rules? Show this in a graph.

2.) When the Canadian government failed to react to changes in conditions in the market for passports, what does its price effectively become? Show the result in a graph.

3.) How did the market work to get around the government decision or indecision in this case? Is there necessarily a value to wasted time under this situation?

Answers:

1.) Since some Canadians all of a sudden needed passports for trips to the U.S., the demand for Canadian passports increased.

In the above figure demand for Canadian passports has increased from D1 to D2 in response to the U.S. change in requirements for Canadian visitors to the U.S.

2.) When the Canadian government does not react to the change in market demand, their price for passports effectively becomes a price ceiling.

In the graph above the Canadian government price for passports after the increase in demand is effectively a price ceiling. Like all price ceilings this one leads to quantity supplied Qs being less than quantity demanded Qd during a particular time period as the graph shows. This will potentially lead to waiting in line for passports.

3.) To get around this price ceiling a market for line place holders arose. Homeless people accepted the job of holding places in line for those who needed passports. This raises the total price of getting a passport and at least reduces the value of wasted time associated with the price ceiling. The payments to the homeless could complete eliminate the value of wasted time if the total price of passports rises to the equilibrium price.

December 10, 2008

New York City just auctioned off some more medallions. What did they go for? About $300,000. What should one cost? Ask Andrew Chamberlain:

...let’s do the math. Given a medallion cost of $300,000, how much does a cabbie have to make to justify buying one? Assuming he’ll use it for 20 years, and assuming a 5 percent discount rate—the forgone return he could’ve earned on a similar investment—he’d need to earn about … $28,300 a year.

That’s not much. So how much do taxi drivers actually earn? According to the New York Times here and here, most drivers pull in about … $30,000 a year.

Chamberlain also questions whether the medallion system makes sense in the first place. My knee-jerk free market reaction is to say no. That being said, it is easy to imagine that a congestion tax on Manhattan taxis is optimal. How close do current quantity restrictions come to such a tax? Hard to say, but at the very least non-Manhattan driving probably does not require medallions. Should we also allow taxis to raise their prices when it is raining? I have heard that Tokyo residents hailing a taxi will hold up two fingers to pay twice the state fare, three fingers to triple it, and so on.

Addendum: Daniel Akst notes that this calculation assumes a very low shadow price for labor. I'll predict that the immigrant drivers have discount rates higher than five percent a year, as well. That only intensifies the puzzle. On the other side of the equation, you can sell the medallion after twenty years.

Activity:

Read the article above.

Questions:

1.) The article indicated that in 2004, a medallion was sold at $300,000. Here comes some update. In May 2007, a taxi medallion was sold in NYC for a price of $600,000. According to supply and demand analysis, is it a surprise to you that a medallion can be sold at such a high price?

2.) Which one will be higher, the price paid by passengers for taxi rides with the medallion system in place or the price they would have paid if there is no medallion system?

3.) Who will favor the medallion system? Why?

4.) Illustrate consumer surplus, producer surplus, and the loss in total surplus (deadweight loss) in a supply and demand diagram caused by the medallion quantity control.

Answers:

1.) The instructor might need to briefly describe the medallion system in the New York City. So the students can understand the situation. The system was introduced to the city decades ago as a quality standard. A taxi driver must obtain a medallion in NYC to be considered as “legal”. Over time, though the population in NYC has increased dramatically, the number of medallions stays almost unchanged. That has caused an obvious problem – not enough taxi rides for passengers who would like to get them.

Given a huge demand and limited supply, it is not a surprise that the price of medallion can reach a record high of $600,000 in 2007.

2.) The price passengers pay for a ride will be higher with the medallion system compared to the price without the medallion system. This can be shown by the following (next page):

In this case, the passengers will have to pay a higher price; these passengers are worse off since they should have paid a lower price. The drivers who do have a medallion will benefit since they receive a higher price; But as a whole, total surplus will drop in the market.

P* and Q* represent the price and quantity without medallion system.

Pm and Qm represent the price paid by passengers and quantity with the system in place.

3.) the taxi drivers who already have the medallion will favor the system given that they receive a higher price Pm instead of P* (and if they decide to sell the medallion in the future, think about it, $600,000!).

4) Using the same graph, consumer surplus and producer surplus can be illustrated.

November 06, 2008

1.) Is the change in driving habits what you would expect from what you have learned in Chapters 3 and 4 about demand and price? If the average car gets 25 miles per gallon, how many fewer gallons would consumers buy if they are driving as much less as the article says?

2.) If the average price of gasoline in the U.S. averaged about $2.50 in March 2007 and averaged about $3.22 in March 2008, based on the data in the article, what is the demand elasticity of miles driven to the price of gasoline?

3.) 11 billion fewer miles sounds like a big change, but what does the estimated elasticity you calculated in question 2.) say about how elastic the demand for miles driven is?

Answers:

1.) Since prices were rising, yes, one would expect the quantity of gasoline purchased--and thus miles driven--to fall. At 25 miles per gallon, consumers would be buying about 440 million fewer gallons of gasoline in March 2008 compared to March 2007.

11 billion miles/25 miles per gallon = 440 million gallons of gasoline

2.) The article tells us the 11 billion fewer miles is a 4.3% drop. We can calculate the percentage change in price by dividing the difference by the average, as in the appendix to Chapter 4 of the Cowen/Tabarrok textbook.

3.) While the change in miles looks pretty big, it is not a large percentage. An elasticity of 0.17 means that miles driven are not very responsive to the price of gasoline at these levels. It took a large percentage increase (25.2%) in the price of gasoline to get this 4.3% reduction in miles driven per month.

November 04, 2008

Abstract: This paper investigates the effects of market-wide changes in health insurance by examining the single largest change in health insurance coverage in American history: the introduction of Medicare in 1965. I estimate that the impact of Medicare on hospital spending is over six times larger than what the evidence from individual-level changes in health insurance would have predicted. This disproportionately larger effect may arise if market-wide changes in demand alter the incentives of hospitals to incur the fixed costs of entering the market or of adopting new practice styles. I present some evidence of these types of effects. A back of the envelope calculation based on the estimated impact of Medicare suggests that the overall spread of health insurance between 1950 and 1990 may be able to explain about half of the increase in real per capita health spending over this time period.

Amy is an assistant professor at MIT; this week's Business Week has an article claiming she is revolutionizing health care economics. Perhaps that is an exaggeration, but her home page is worth a look.

Everywhere we look it seems that health care is more expensive: prescription drug prices are increasing, costs to visit the doctor are up, the price of health insurance is rising. But look closer, even closer, closer still. Don't see it yet? Perhaps you should have your eyes corrected at a Lasik vision center.

Laser eye surgery has the highest patient satisfaction ratings of any surgery, it has been performed more than 3 million times in the past decade, it is new, it is high-tech, it has gotten better over time and... laser eye surgery has fallen in price. In 1998 the average price of laser eye surgery was about $2200 per eye. Today the average price is $1350, that's a decline of 38 percent in nominal terms and slightly more than that after taking into account inflation.

Why the price decline in this market and not others? Could it have something to do with the fact that laser eye surgery is not covered by insurance, not covered by Medicaid or Medicare, and not heavily regulated? Laser eye surgery is one of the few health procedures sold in a free market with price advertising, competition and consumer driven purchases. I'm seeing things more clearly already.

Thanks to Jonathan Van Loo for research assistance on this post.

Activity:

Rising health care costs continue to be a source of concern for policy makers. Health care expenditures account for approximately 16% of GDP, up from 6% in 1960. In recent years, the growth rate in spending has been near 7%. Many economists believe that insurance plays a role for the rise in health care costs.

Tyler Cowen linked to the recent research of Amy Finkelstein who wrote, “…the overall spread of health insurance between 1950 and 1990 may be able to explain about half of the increase in real per capita health spending over this time period.”

Alex Tabarrok suggests that the falling real price of laser eye surgery is attributable to a lack of insurance. Private insurance and government programs such as Medicare and Medicaid do not cover the procedure.

In Chapter 3, Cowen and Tabarrok explain that rising prices may result from an increase in demand or a decrease in supply. Since insurance alters the price of health care paid by consumers, it is the demand for health care that is affected by the presence of insurance. Suppose that the market price for a physician office visit is $100. A consumer who has an insurance policy that covers 85% of all costs will only incur a $15 charge for each visit. In this case, the consumer has a 15% coinsurance rate—i.e., she is responsible for 15% of all costs. The consumer will now pay a lower effective price for physician office visits, leading to more visits to the physician.

We can analyze the effect of insurance by using a simple linear demand function, say, of the following form:

Q = 500 – P, where Q is the quantity of physician office visits and P the price per visit.

A graph of the demand function appears below. If the market price is $200, and consumers are without insurance, quantity demanded is 300.

Suppose that the consumers now have an insurance policy that pays 80% of the market price, leaving consumers with a 20% coinsurance rate. The effective price paid by consumers with insurance is $40 (.20 x 200). In general, the effective price with insurance is equal to the coinsurance rate (c) times the market price (P), or cP. The demand equation with insurance becomes:

Q = 500 – cP

Given the 20% coinsurance rate, the demand function is Q = 500 – 0.2P, which is shown below along with the original demand curve.

At the market price of $200, consumers will increase their office visits to 460 (Q = 500 - .2 x 200). The insurance insulates the consumers from the $200 market price; they act as is if the market price is only $40 (.2 x 200) and, as shown above, this causes an increase in demand.

Another interesting aspect of insurance is that it creates a deadweight loss. The market is providing health care at a market price of $200, which reflects the marginal costs of care, but consumers are purchasing units of care that they value less than the cost. The deadweight loss is the triangle area between 300 and 460 office visits. In this range, the market price exceeds the marginal value (reflected in the height of the demand curve) of the visits, creating an inefficiency. Note that higher coinsurance rates reduce the deadweight loss.

Questions:

1.) Graph the market demand for wellness visits, which is given by Q = 200 – 2P. Graph a new demand curve assuming that consumers have an insurance policy with a 50% coinsurance rate.

2.) If the market price per visit is $50, how many visits do consumers purchase with and without insurance?

3.) What is the deadweight loss attributable to insurance?

4.) Given that insurance increases the demand for health care, what is the new equilibrium price of visits if the market supply function is Q = 50 + P.

November 03, 2008

Potting mixes often contain sphagnum peat moss from bogs in Canada or Ireland. Bark fines might come from a sawmill in the Deep South. Coconut "coir," a peat moss substitute, gets shipped all the way from Asia.

A common ingredient in potting mixes is perlite, which makes the soils airier while also retaining moisture. In its final form, small white pellets, it appears to be something synthesized in a factory. In fact, it comes from a volcanic sand mined on the Greek island of Milos. Shipped to the United States, the ore is heated to 1,400 degrees Fahrenheit, at which point it pops into kernels.

In class, we often sum up the gains from trade by imagining that countries trade final goods, things that are ready to sell: The U.S. sells jets and China sells TVs, for example. But a lot of what gets moved around between countries aren’t final goods, they’re important intermediate goods, stuff that becomes part of another final product. Some of these intermediate goods aren’t very glamorous, such as perlite.

Question:

1.) Imagine that you are the U.S. trade official, and the U.S. Artificial Perlite Industry Council (APIC) comes to you asking for increased tariffs on Greek perlite. The APIC’s argument: “How can we compete with volcanic rock that the Greeks just scoop up, heat up, and ship? In order to pay high wages to our artificial perlite factory workers, we have to charge twice the Greek price. You can create 200 good-paying factory jobs if you put a 100% tax on perlite.”

What’s your counterargument? Or do you agree with the U.S. artificial perlite industry?

What is it that shifts the supply curve?Which direction does it shift in?

2.) Now draw a supply and demand diagram of the market for milk: What is it that shifts the supply of milk?

3.) What does Alex mean when he says that “capitalist production system minimizes waste?”Example: If a business owner turns the lights off at his factory every night instead of just keeping the lights on all night, who pockets the savings?